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The Effects of Foreign Shocks when Interest Rates are at Zero

Listed author(s):
  • Bodenstein, Martin
  • Erceg, Christopher J.
  • Guerrieri, Luca

In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound on policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. Departing from many of the existing closed-economy models, the duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the trap, implying more contractionary effects for the home country. The home economy is more vulnerable to adverse foreign shocks if the neutral rate is low – consistent with "secular stagnation" – and trade openness is high.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 983.

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Length: 34 pages
Date of creation: 2009
Date of revision: 03 Oct 2016
Handle: RePEc:fip:fedgif:983
DOI: 10.17016/IFDP.2016.983r
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